Unexpected News Serves as a Reminder of the Value of Diversification

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
Equities ended the week lower with surprises to start and end the week serving as bookends for a volatile ride for investors. The week started with unexpected news out of China that a new artificial intelligence (AI) model from the Chinese company DeepSeek was able to compete with established AI large language models at a fraction of the cost of development. The news sent shudders through the tech industry as concerns grew that less capital-intensive AI technology could lead to lower than expected technology investment by companies. The lower spending, as the thinking goes, would in turn lead to weaker sales for some of the IT firms that have seen their valuations surge thanks to expectations of significant sales growth.
Friday’s jolt came from the White House announcement that the U.S. would impose tariffs of 25 percent on goods form Canada and Mexico and 10 percent on products from China beginning February 1. That news sparked selling pressure and sent the major indices that had been up for the day to close with losses. We highlight these two events because we believe they illustrate the value of diversification in an unpredictable world. Indeed, the market’s reaction to the DeepSeek news was particularly noteworthy. After the news broke, the S&P 500 tumbled, with the market-cap-weighted version of the index losing 1.5 percent for the day. Overall, the Magnificent Seven were down 3.84 percent, driven by Nvidia’s 17 percent drop for the day. Given that the Magnificent Seven accounts for more than one-third of the value of the S&P Index, the entire market-cap-weighted index suffered. Contrast that with performance for the equal-weight version of the S&P, which finished the day up .02 percent. The positive performance for the equal-weighted index was the result of 199 more stocks rising than falling that day. This is the type of broadening in the market that we believe is necessary for continued gains in 2025.
To be sure, there will be days when a surprise or new development will hurt a sector other than technology and the Magnificent Seven, with Large-Cap tech stocks as a whole left unscathed. However, we believe the level of investor concentration in Large Caps has resulted in elevated risks. Avoiding those elevated risks can be achieved by following a diversified investment plan that recognizes that economic surprises are part of the business cycle and that asset classes go in and out of favor—often with little or no advanced notice.
Being a prudent, disciplined investor who adhered to the value of diversification meant not fully benefiting from the run up of the Magnificent Seven in 2023 and 2024. While it may be cold comfort now, it is important to remember this is not the first time investors have flocked to what seemed like a “can’t-miss” group of stocks that were trouncing other parts of the market. Whether it was the group of Large-Cap blue-chip names, such as the Nifty Fifty in the early 1970s, technology stocks in the late 1990s or Emerging Market stocks in the mid 2000s, the history of investing is littered with what were seen as sure opportunities that were believed to be unique enough that the time-tested value of diversification was deemed by some as no longer relevant. In each case, however, the circumstances that led to the group’s outperformance eventually faded, and the favored asset classes or sectors eventually fell from their perch.
As to performance over the past few years for Large Caps (and the Magnificent Seven in particular), it’s important to note that outsized returns have been the result of a narrow economy and investors looking to ride out uncertainty in a handful of stocks that they believe are mostly insulated from a potential slowdown in the economy if the Fed is unable to reduce rates. We believe this dynamic will change as a result of either a resumption of disinflationary trends that allow the Fed to cut rates more than investors currently expect in 2025, a mild slowdown that snuffs out lingering price pressures, or simply the passage of time (during which businesses are able to adjust to higher interest rates).
Indeed, we are now seeing glimmers of improvement in those parts of the economy that have struggled with higher interest rates. Should this continue, we expect the economy will broaden as will earnings in many of these overlooked areas of the market, which should translate to better performance.
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Fed holds rates steady: As expected, the Federal Reserve voted to hold rates last week after cutting rates during each of its three previous meetings. In comments after the announcement, Fed Chair Jerome Powell noted that employment data and recent inflation readings should allow the Fed to take a deliberate approach to rate cut decisions in the months ahead. “The economy is strong, the labor market's solid, downside risk to the labor market appears to have abated, and we think disinflation continues on a slow and sometimes bumpy path. That tells me and the other members of the Committee ... that we don't need to be in a hurry to adjust our policy stance.”
Inflation little changed: The latest reading of the Personal Consumption Expenditures (PCE) index from the Bureau of Economic Analysis showed that headline inflation rose 0.3 percent in December and is up 2.6 percent on a year-over-year basis. Core inflation, which strips out volatile food and energy prices and is the measure that the Fed has the greatest influence over, also rose 0.2 percent in December—in line with Wall Street estimates and up from November’s pace of 0.1 percent. On a year-over-year basis, core inflation was up 2.8 percent, marking the third consecutive month the pace has been stuck at this level. This marks the sixth consecutive month that the 12-month reading has come in at 2.7 percent or above. Put simply, we appear to be “stuck” at a pace that is still above the Fed’s 2 percent target. Fed Chair Powell noted at his press conference last week that the Federal Open Market Commitee would be willing to cut rates before inflation sustainably reaches its 2 percent target; however, board members want to see additional progress showing that prices are retreating from their current stuck position. We believe this is likely why the Fed is projecting a slower pace of rate cuts in 2025.
The cost of goods rose 0.2 percent in December after being little changed in November. Services prices rose by 0.3 percent, up from November's pace of 0.2 percent. On a year-over-year basis, inflation for services came in at 3.8 percent, unchanged from November’s reading. This marks the eighth consecutive month that services inflation has registered year-over-year growth in a range of 3.7 to 3.9 percent and suggests that progress in the disinflationary process has slowed.
The lack of significant progress in the fight against inflation was also captured in one of the secondary reports we follow. The Dallas Federal Reserve’s Trimmed Mean PCE, which removes outliers that can distort traditional PCE readings, shows that the one-month annualized inflation rate is at 2.76 percent and is up 2.77 percent during the past 12 months. For context, with the exception of the spike during COVID and during a few months in 2006 and 2007, the current reading is the highest it’s been since 1992 and likely is too high for the Fed’s comfort.
GDP points to solid growth: The initial estimate of fourth-quarter real gross domestic product (GDP) growth from the Bureau of Economic Analysis came in at 2.3 percent, falling short of Wall Street expectations of 2.7 percent. However, for the full year, GDP is estimated to have grown 2.8 percent. The increase in quarterly growth was driven by consumer spending, while private domestic investment by consumers and businesses fell. These are strong numbers that are above what many consider to be sustainable in the long run. Given the strength and the seemingly strong employment picture, we believe, barring any surprises, the Fed will be content to leave rates at their current levels for the near term.
Consumer confidence weakens: The Conference Board’s Consumer Confidence Index released last week came in at 104.1 for January, down 5.4 points from December’s final reading. Views of current economic conditions dropped sharply, coming in at 134.3, down 9.7 points from the prior month. Expectations for the future declined 2.6 points for the month to 83.9. Declines were seen in each of the five measures used to measure consumer views.
The labor differential, which measures the gap between those who find it hard or easy to get a job, tumbled to 16.2 from December’s reading of 22.2 percent. Still, the level is well below the record high of 47.1 recorded in March 2022. For further context, the latest reading breaks an uptrend that had been in place since the measure hit a recent bottom of 12.7 in September 2024. Respondents also aren’t optimistic about the future of the job market.
More respondents expect the number of available jobs to decrease in the next six months, and fewer expect their income to rise.
Similar to what we’ve seen in the University of Michigan Consumer Sentiment survey, respondents are expecting inflation to rise in the coming year. The latest results from the Conference Board show the expected inflation rate in the year ahead rose to 5.3 percent in January from 5.1 percent the previous month. Perhaps not surprisingly given rising inflation expectations, 51.4 percent anticipate interest rates will move higher over the next year. Likewise, the portion of those expecting lower interest rates in the coming year fell to 23.9 percent in January, down 4.6 points from the prior month.
Existing home prices hit another record high: Home prices reached another seasonally adjusted record high in November, according to the latest S&P CoreLogic Case-Shiller Index. The latest report shows that home prices nationally rose 0.4 percent on a seasonally adjusted basis from the prior month. November’s reading shows home prices are up 3.8 percent on a year-over-year basis, compared to October’s year-over-year pace of 3.6 percent. While the pace of year-over-year gains has eased since July 2024, mortgage interest rates have moved higher. The continued rise in selling prices and rise in mortgage rates means affordability issues continue for average buyers.
New home sales rise: New home sales rose in December to a seasonally adjusted annual rate of 698,000 units, according to the latest data from the U.S. Census Bureau. This figure is up 3.6 percent from November’s revised total of 674,000. On a year-over-year basis, new home sales are up 6.7 percent from the December 2023 estimate. In total, 683,000 new homes were purchased in 2024, up 2.5 percent from the prior year and in line with the 682,000 sold in 2019. While 2024’s total was similar to pre-COVID levels, sales prices have skyrocketed. The median price of a new home in 2024 was $420,100, which is down 2 percent from 2023 but up a significant 30 percent from 2019’s price of $321,500.
The housing market has been constrained by a lack of inventory. There’s some good news here in the latest data, with new home inventory now standing at 496,000 units, the highest level since 2007. Given that existing home sales make up the vast majority of sales, the increase in new home inventory isn’t likely to cure the shortage of units, but it does mark an improvement.
The week ahead
Monday: The Institute for Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Recent readings have shown signs of improvement in manufacturing, and we will be watching to see if the sector is showing signs of expansion. We will also be evaluating the data for signs of increased input cost pressures.
Tuesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for December. We’ll watch for changes in the gap between job openings and job seekers. We’ll also keep an eye on the so-called quits rate to see if workers are feeling confident in their ability to find different or better jobs.
Wednesday: The ISM will release its latest Purchasing Managers Services Index mid-morning. Last month’s report showed uneven growth in the services sector and increased inflationary pressures. Given that the services side of the economy has driven much of the economy’s growth over the past two years, we will be looking for signs of any changes in underlying strength in this report.
Friday: The BLS will release the Jobs report. We’ll be watching to see if last month’s hiring continued in January. Importantly, we will be monitoring the pace of wage growth. Last month’s data showed the pace of wage growth eased, and we will be looking to see if that trend continues, as it could weigh into the Fed’s thinking on rates in the future.
The University of Michigan will release its preliminary report on February consumer sentiment and inflation expectations. Inflation reports have been on the rise in recent months and have started to move consumers’ views on “buying ahead” of potential price increases.
NM in the Media
See our experts' insight in recent media appearances.
Brent Schutte, Chief Investment Officer, discusses the latest on interest rates and where there are opportunities in the market for the year ahead.
Matt Stucky, Chief Portfolio Manager-Equities, provides his view on Small and Mid-Cap stocks and his expectations for Fed rate cuts for the remainder of the year. Watch
Matt Stucky, Chief Portfolio Manager-Equities, provides his outlook for Fed policy ahead of this week’s Jackson Hole symposium, as well as an overlooked indicator he is tracking to gauge the underlying strength of the economy. Watch
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